Posts Tagged ‘creditors’

It’s not very often that the U.S. Supreme Court involves itself in legal issues related to estate planning and elder issues. Last week, though, the Court did just that — by ruling that an inherited IRA is not exempt from the beneficiary/owner’s creditors, at least in a bankruptcy proceeding. What does the decision (in Clark v. Rameker, June 12, 2014) mean for you, and is there any way for you to avoid the result suffered by Heidi Heffron-Clark?

First, let’s figure out how much of a problem the Supreme Court decision creates for you. Let’s suppose that you have diligently contributed to your own IRA, and that you have managed to accumulate a significant sum — just to give it a figure, let’s suppose that your IRA is now worth $300,000. Now suppose that you are involved in an auto accident, and you are sued for injuries caused by the accident. Of course you have auto insurance, and that should take care of most or all of the liability. If your insurance is inadequate, though, can the injured party reach your IRA? The short answer (subject to a handful of exceptions unlikely to apply to you) is an emphatic “No.”

But what if you get divorced — can your soon-to-be-ex-spouse get a share of your IRA? The answer here is generally a qualified “Yes,” but there are specific rules that have to be applied and your actual answer will be very dependent on state law and facts about your marital situation.

One more theoretical question about your theoretical IRA: if you have a series of financial reverses and have to file for bankruptcy, will your IRA be scooped up the bankruptcy court (more accurately, the bankruptcy trustee)? Generally, the answer here is “No.” Your IRA is, in most cases, protected from your creditors — even in bankruptcy.

Does it make a difference if your retirement account is not an IRA but a 401(k) account? No. IRAs, 401(k)s, 403(b)s and most other retirement accounts are similarly protected from creditors and bankruptcy trustees.

Now let’s assume that you didn’t build up that IRA at all — your wife did. She contributed all during her work life, and then she tragically died before she could benefit from the retirement account. She named you as beneficiary, and you “rolled over” her IRA (it could have been a 401(k) or 403(b) — the same rules apply) into a new IRA in your own name. You are now treated as the owner of the roll-over IRA, and it is still exempt from creditors — even though it was inherited.

You can probably see where this is going next. The situation in the Supreme Court case was the next step: Heidi Heffron-Clark’s mother Ruth Heffron was the one who actually built up the IRA. When she died, she named her daughter as beneficiary. Ms. Heffron-Clark was required to begin withdrawing the inherited IRA on a regular schedule, but she chose to leave everything she could in the IRA to continue to earn money tax-free. Then she got into financial trouble, and filed for bankruptcy. The trustee in her bankruptcy proceeding asked the bankruptcy court to order transfer of the IRA to him; he intended to liquidate the IRA and use it to pay Ms. Heffron-Clark’s creditors. She objected that IRAs are exempt from creditors’ claims and bankruptcy, but the court allowed the trustee to gain access.

Ms. Heffron-Clark asked the Federal District Court to overrule the bankruptcy court, and it did. Then the Court of Appeals reversed that finding, ruling that the bankruptcy court (and the bankruptcy trustee) had been right all along. The Supreme Court agreed to review the case, partly because another Court of Appeals from a different Circuit had ruled that an inherited IRA was safe from the bankruptcy trustee. It was important to have a single answer applicable in all U.S. bankruptcy courts.

The Supreme Court agreed that Ms. Heffron-Clark’s inherited IRA had to be paid over to the bankruptcy trustee, and used to pay off some of her debts in bankruptcy. The federal bankruptcy law’s exemption of “retirement funds” did not apply to inherited IRAs, according to the Court, because they were not anyone’s retirement savings — though they were before the original owner’s death.

Now suppose that Ruth Heffron had wanted to preserve her IRA for her daughter, knew that her daughter’s financial health was precarious, and knew that she would likely not live long enough to use the entire retirement account herself. Was there anything she might have done to avoid the result announced in last week’s Supreme Court decision? Yes, as it happens — Ms. Heffron could have simply named a trust for the benefit of her daughter as beneficiary of the IRA (rather than naming her daughter directly), and included appropriate limitations in the trust to protect it from her daughter’s creditors. We have often advocated for creating trusts for inheritances generally, and the Clark v. Rameker decision makes that idea much more compelling, especially for large retirement accounts.

Why would the result be different? Not because there is anything special about retirement accounts, but because it is relatively easy to protect inheritances from the recipient’s creditors by leaving the inheritance in trust — and that same principle applies to retirement accounts. The trust itself is slightly more challenging to create, but worth the effort in many, perhaps most, cases.

JANUARY 17, 2011 VOLUME 18 NUMBER 2
We frequently are asked to explain the differences between different types of trusts, or to analyze a trust with no more information than its type. Confusion about the differences is widespread, and we hope to provide a little clarity to consideration of trust types.

Before we embark, we have three caveats:

We are not trying to list every possible type of trust here, but just those our clients most often encounter. We may expand this list over time.

Just because you believe your trust is, for example, a “spendthrift” trust does not necessarily make it so. Even if the name of the trust includes one of these categories, it might be inaccurate. The type of trust is determined by the language of the trust itself, and it may take some close reading to identify a trust’s correct categorization.

Most of these categories are neither magical nor exclusive. Just because we can categorize a given trust as a “spendthrift” trust, for example, it does not necessarily mean that it will be protected against all of the beneficiary’s creditors. And just because a trust is a “spendthrift” trust does not mean it could not also be a “special needs” trust, a “bypass” trust or some other category.

With that out of the way, let’s get started on a partial list of common types of trusts you might encounter (or create):

Spendthrift trust. This trust is protected against the creditors of a beneficiary. The trustee can not be compelled to make distributions to a beneficiary, or to the beneficiary’s creditors. This does not necessarily mean that the trustee is not permitted to make such distributions (after all, it might be in the beneficiary’s best interests to pay his or her debts). Even very strong spendthrift language might not be effective against some types of creditors in some states. Common exceptions adopted by state law include child support and alimony obligations or governmental debts. State laws vary widely on these lists.

“Third-Party” Special Needs trust. These trusts are usually specialized spendthrift trusts created for a beneficiary who suffers from a disability. The language of the trust will usually include a clear expression of the intent that the trust’s monies should not interfere (or not interfere too much) with the beneficiary’s public benefits, like Supplemental Security Income or Medicaid. The variation here from state to state, and from beneficiary to beneficiary, can be tremendous, so be very careful about generalizing when discussing third-party special needs trusts.

“Self-Settled” Special Needs trusts. Just to keep the confusion level high, there are also special needs trusts created by the beneficiary himself or herself. Of course, a beneficiary with a disability may have to act through a court proceeding, a guardianship or conservatorship, or a parent or grandparent. But whoever signs the actual documents, if the money in a special needs trust comes from the beneficiary’s own resources (like a personal injury settlement, or an unrestricted inheritance) then the special needs trust will be treated as a self-settled trust. That means the rules will be more difficult, both as to creation and administration of the trust. Can a self-settled special needs trust also be a spendthrift trust? What an interesting question you ask.

Bypass trust. Sometimes these trusts are called “credit shelter,” “exemption,” “decedent’s,” or just “B” trusts, but all of those names are pretty much interchangeable. The basic premise of a bypass trust is that a married couple arranges to take full advantage of the federal estate tax exemption amount, so that they can pass up to twice that amount to their heirs on the second death. That means that on the first spouse’s death a portion of the couple’s assets transfers to the bypass trust irrevocably, with some limitations on the use of the money during the surviving spouse’s life.

Bypass trusts are a special breed just now. Because the new federal estate tax law allows a married couple to retain both estate tax exemption amounts without having to create a bypass trust, there are a lot of trusts out there that may not still be needed. If both spouses are still alive it may be time to change the documents. If one spouse has already died the problems are more complicated. About the time we all figure this out (in two years) the estate tax provisions are scheduled to end automatically. We will have to wait most of those two years to find out if bypass trusts will fade out of existence.

Revocable trusts. Any trust that can be revoked — by anyone, but usually by the person who established the trust — is “revocable.” You may sometimes see the phrase “revocable living trust,” which means the same thing. If the only person who can revoke the trust has died (or become permanently incapacitated) then the trust has become irrevocable. Even if the name of the trust includes the word “revocable” (as, for instance, “The Smith Family Revocable Trust”) it may now be irrevocable.

Irrevocable trusts. The flip side of a revocable trust is, obviously, an irrevocable trust. The category just means that no one has the power to revoke the trust. That does not mean it will go on forever — if the assets held by the trust are spent or distributed, it ceases to exist even though it was irrevocable.

Grantor trusts. This term is most important in considering federal income tax liabilities, but it is often used more broadly. In a nutshell, a grantor trust is one in which the person who established the trust has retained one or more of the elements of control listed in the federal income tax code. Most important (but not the only ones) are: the power to revoke the trust, the right to receive the trust’s income and/or principal, and the role of trustee. Grantor trust rules are actually quite complicated, and are sometimes subject to some interpretation — fortunately, the shades of meaning don’t show up very often. Most trusts are either quite obviously grantor trusts or quite clearly not.

Those are some of the most common terms you might see to describe trusts. In a future Elder Law Issues we will tackle some of the less common ones, like “Crummey” trusts and ILITs, QTIP and QDoT trusts, and — well, feel free to ask us to try to describe/define your favorite trust category.

What makes a trust a “spendthrift” trust, and what does it mean? A recent Florida Court of Appeal case gives a good snapshot of the significance and the effect of the categorization.

Elizabeth Miller wanted to leave her property to her two sons, but wanted to protect against her money being subjected to the claims of their creditors. This was particularly important to her because one son, James F. Miller, had already been sued over a business deal gone bad. In fact, there was a million dollar judgment on record and the plaintiffs were trying to collect from James.

Ms. Miller left James’s share of her estate in a trust with her other son, Jerry Miller, as trustee. The language of the trust authorized Jerry to give James any or all of the trust’s assets, but ordered that he not turn over anything to James’s creditors. Within weeks of making that change, Ms. Miller died and her estate passed partly to Jerry as trustee of James’s trust.

James’s creditors sued Jerry and the trust, claiming that James really exercised control over investments, distributions and trust decisions. The trial court agreed, and ruled that James had so much control over the trust and his brother that his interest in the trust had effectively “merged” into an ownership interest. The court’s order allowed James’s creditors to get to his inheritance.

Not so fast, said the Florida Court of Appeal. The appellate court agreed that James had effectively made trust decisions in place of Jerry, but noted that Jerry had the power to take back control at any time. It is the language of the trust itself and not the behavior of the trustee or the beneficiary that must control whether a spendthrift provision is effective, said the judges.

Had Ms. Miller’s trust given James the right to demand principal (or income) from the trust, that would have been a different matter. Because the decision to make those distributions ultimately rested with Jerry as trustee, James’s creditors could not reach behind the trust to gain access to the assets directly.

The appellate court agreed that “the facts in this case are perhaps the most egregious example of a trustee abdicating his responsibilities to manage and distribute trust property.” Nonetheless, the failure of the trustee to exercise control over the trust did not invalidate the spendthrift provision itself, and James’s creditors could not gain access to his inheritance. Miller v. Kresser, May 5, 2010.

Would Arizona courts have the same high regard for spendthrift provisions? Probably, if the trust’s property did not originally belong to the beneficiary. An individual can not create a spendthrift trust to protect his or her own property from creditors — though there are some exceptions. The most important exception under Arizona law is for trusts established for a beneficiary with a disability — so-called “special needs” trusts.